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East Asia's Challenge to Standard Economics

Have successful developing countries thrived by conforming to the laws of the free market, or have they prospered by defying them?

A recent wave of industrialization has surged over countries ranging from South Korea, Taiwan, and Japan to Brazil, Mexico, Turkey, and India. These late-industrializing countries started to grow by borrowing rather than inventing technology, which had been the hallmark of earlier industrial revolutions. Wherever it has succeeded, late industrialization based on borrowed technology has some common characteristics that compensate for the lack of pioneering products or processes. Typically, governments have used subsidies to encourage businesses to become internationally competitive, and businesses have focused strategically on the shopfloor to make the best use of the technology they have borrowed.

According to the theory of free trade, the great comparative advantage of developing countries is low wages. And it is true that all recent or late industrializers have relied on unusually repressive labor conditions to grow. Nevertheless, cheap labor has been an insufficient competitive asset in all but the most labor-intensive industries. And industries relying on unskilled labor have not acted as an engine of growth or provided an entry point to the more advanced sectors requiring complex skills and modem capital equipment.

In the 1960s Korea's and Taiwan's low wages and borrowed technology were no match for Japan's high productivity even in cotton spinning and weaving, the classic case where the theory of free trade predicts underdeveloped countries should enjoy a comparative advantage. Seoul and Taipei lowered the comparative cost of their labor through repeated devaluations of their currencies. Though they eventually aligned their exchange rates with the forces of supply and demand, they still did not gain a decisive edge over Japan. So the South Korean and Taiwanese governments intervened to stimulate industrial growth.

Alexander Gerschenkron, the late Harvard economic historian, was among the first to recognize the importance of government intervention in European industriahzation. Japanologists also realized belatedly the government's key role in the economic miracle of Japan. This same recognition slowly dawned on students of the newly industrializing countries, but exactly what states did when they intervened was much disputed. Some said states "induced investment," but inducement covers a multitude of sins against the market. The government of Japan closely cooperated with business as Japanese industrial cartels entered new markets, resulting in the caricature of Japan, Inc. According to Gerschenkron, European governments also arranged finance for their national industry due to the historical weakness of private banking.

In the developing world today, state intervention has produced extraordinarily rapid growth in East Asia. Yet much the same type of intervention seems the villain behind sputtering growth in Latin America, Turkey, and India. This paradox has been resolved by invoking the First Commandment of the economic development establishment: Thou shalt get prices right. According to the International Monetary Fund and kindred organizations, intervention in Latin America, Turkey, and India failed because governments had defied the price mechanism. Intervention allegedly succeeded in East Asia because the government had "gotten relative prices right."

Getting Prices "Wrong"
In fact, through East Asia and elsewhere, all governments in countries that compete without new technology have used subsidies deliberately to get relative prices "wrong" to stimulate investment and trade. The East Asian countries have not grown faster because they have bowed more deeply at the altar of free markets. They have grown because they did not hesitate to distort prices from what they would have been if the forces of supply and demand operated freely. To bring about industrialization, they have especially distorted two pivotal prices: the exchange rate and long-term interest rates.

To control interest rates, both South Korea and Taiwan nationalized all banks and closely regulated other financial institutions, with the exception of an unofficial curb market. They created, in effect, a three-tiered interest rate structure. Real interest rates in the South Korean curb market ranged between 15 and 20 percent, representing a free market rate responsive to supply and demand. Real commercial bank interest rates, set by the government for important borrowers, averaged about one-fourth as much. And real interest rates on foreign loans, reserved for the most-favored firms in targeted industries, were consistently negative, given fixed exchange rates and high domestic inflation.

Since there were three different prices for capital, not all prices could have been right. The most important price, the real interest rate on long-term foreign loans, was fundamentally "wrong" for over 25 years -- that is, negative in an acutely capital-scarce country. The government not only arranged finance for favored firms, but also priced it below market to create profitable investments.

The two pillars of free trade theory are comparative advantage and the price mechanism, but in practice, countries that must borrow technology to grow have no comparative advantage in manufacturing based on free market prices. Their governments must intervene with subsidies to supplement the advantage of low wages. Some economists might argue that these subsidies represent no more than "infant industry protection." But the subsidies have lasted longer and penetrated more deeply into the economy than any reasonable definition of "infant industries" might suggest.

When "Wrong" Prices are Right
Despite the fact that late-industrializing countries share the same paradigm, they have had varying degrees of success with state intervention. One key difference lies in the principles governing subsidy allocation. In the less successful countries, from Latin America to Eastern Europe, the allocation of subsidies has been a free-for-all; the give-away principle has reigned supreme. On the other hand, in Japan, South Korea, and Taiwan (and to some extent Brazil), subsidies have been allocated in exchange for performance standards. The distribution of subsidies has been relatively disciplined. All "developmental" states that have succeeded in transforming their countries from raw material producers have exercised discipline over labor. What sets Japan, South Korea and Taiwan apart is their discipline of business.

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Historically, the United States has used regulation of industry to prevent the rise of monopolies. The South Korean government, in contrast, cradled the growth of huge conglomerates in the belief that bigness was necessary to attain international competitiveness, not least of all against Japan's big business groups. In Taiwan, large state enterprises served the same function as private conglomerates and, at the outset of industrialization, accounted for over 50 percent of value added in manufacturing. Discipline in East Asia has taken the form of controlling big business, not preventing business from getting big. Fierce competition among big business groups in East Asia has been a consequence of growth, not a cause of it.

While big business has received subsidized credit, it has also been restrained from raising prices and exporting capital. To prevent abuse of monopoly power, the South Korean government has imposed price ceilings on products ranging from nylon stockings, peppers, and cars to steel, paper, and cement. Illegal capital flight has been punishable in South Korea with a minimum of ten years' imprisonment and a maximum of the death penalty East Asian companies have been allowed to hire labor at low wages, but they have had to provide labor training and pay high wage increases. Real average wage increases in South Korea have been exceptionally fast by the standards of previous industrializations and other late-industrializing countries. (The gap between men's and women's wages, however, is greater in Japan and South Korea than almost anywhere else in the world, mainly because women are pressured to leave paid employment when they marry!)

To prevent Japanese takeover of its industry, Korea has approved foreign investments very selectively. The foreign multinational firm is a virtual stranger in South Korea. There is more foreign investment in Taiwan, but not in the "commanding heights." Industry has also been protected against imports. For example, no foreign car was to be seen on South Korean roads for 25 years; during that time no South Korean car was seen on foreign roads. South Korean and Taiwanese firms eventually had to export. Exacting export targets, negotiated in South Korea between business and government, have forced firms in virtually every industry to increase exports by raising quality and productivity, rather than through dumping.

Exports and High Productivity Growth
Slower-growing, late-industrializing countries with large domestic markets cannot, and should not, export as much of their gross national product as do South Korea and Taiwan. Nevertheless, even modest export targets provide unambiguous, transparent standards for measuring the performance of subsidy recipients. Other countries might well imitate this emphasis on performance measures. South Korea has one of the highest productivity growth rates in the world. Even as South Korea piled up foreign debt to finance a big push into heavy industry, its debt/GNP ratio did not rise, a tribute to the ability of Korean industry to boost production.

No firm in Taiwan or South Korea could make it big unless it was a staunch government supporter. Nevertheless, despite pervasive corruption surrounding the allocation of subsidies, discipline over firms has been effective: generally poor performers have been punished, and only good performers have been rewarded.

I studied small machine tool firms in Taiwan and over thirty big businesses in South Korea for a period of almost ten years, examining company policies and shopfloor practices. Performance was generally impressive, not necessarily in terms of return on investment, which cannot be measured accurately, but in terms of physical indicators of production and operations management, such as reject rates, raw material wastage, throughput time, and new product introductions. Profits were routinely reinvested in new plants, technology, and training.

The Production Engineer
In industrializations based on learning, a key figure is the student. Borrowing technology was especially successful in East Asia partly because heavy investments were undertaken in education, both formal schooling and foreign technical assistance. South Korea and Taiwan were fortunate to get the preponderance of their foreign technical assistance from Japan, a learner itself.

The emphasis in hiring was on science and technology Between 1960 and 1980 employment in South Korea of general managers rose two-fold. The employment of engineers rose ten-fold. A large number of engineers competing for the best jobs and promotions underpinned high productivity gains.

In recent industrializations, the need to make borrowed technology work has produced a strategic focus on the shopfloor. The owner-entrepreneur was the hero of the First Industrial Revolution in Great Britain. The corporate manager was the protagonist of the Second Industrial Revolution in the United States and Germany a century later. The production engineer, as extolled by Thorstein Veblen, is now the leading actor of industrial transformation. The production engineer has the technical knowledge to adapt, improve, and optimize borrowed technology. Incremental quality and productivity improvements have become late-industrializers' competitive asset.

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Because resources in late-industrializing countries have been used to build shopfloor capability rather than large corporate offices, the rise of managerial capitalism has not sent overhead expenses through the roof. The ratio of managers to production workers in Korea remained constant between 1960 and 1980, even declining slightly.

Governments in East Asia don't directly interfere in production, but indirectly the interference has been great. State banks and economic planning boards work closely in South Korea with big business groups. Big business groups such as the zaibatsu in Japan, the chaebol in Korea, and los grupos in Latin America are a general feature of late industrialization. The groups tend to be more widely diversified than many giant American corporations because they have lacked technical expertise to move vertically into higher quality niches within any single product line. But despite their entry into the bottom end of many markets, they have tended to be more tightly coordinated at the top than American conglomerates. Unlike earlier industrializers, they expanded quickly under their original owners without a dilution of their equity by borrowing foreign technology and capital.

The upshot in East Asian industrialization is a closely coordinated approach to growth, with the corporations in tight control of their subsidiaries, subsidiaries in close touch with their shopfloors, and linkages running from top government ministers to the heads of big business groups.

Why East Asian States Promote Growth
Many economists assume that government officials are "rent seekers," using public office for personal gain. Nowhere in the world is government perfectly clean, but politicians and officials are by no means equally corrupt. Some can, and do sacrifice short-term greed for long-term growth -- and other values.

Where the probability of achieving growth is high, politicians have a stronger incentive to make industrial expansion a priority. Even on a cynical view, systematic capital accumulation provides far greater opportunities for state officials to enrich themselves than the alternative of trying to rip off existing resources. In countries where the probability of sustained economic development is low -- Haiti and some other poor Caribbean and African countries come to mind -- infamous rent-seeking on the part of the government is more common.

Like most underdeveloped countries today, South Korea and Taiwan in the 1960s fell somewhere between these two extremes. Both the South Korean and Taiwanese governments became developmental gradually and pragmatically (remember the rent-seeking regimes of Syngman Rhee and Chiang Kai-Shek). As subsidies to business produced rapid growth, the governments allocated more subsidies, which increased growth further, and so on in a virtuous circle.

What distinguishes the South Korean and Taiwanese states today is their greater power to discipline private business and the greater capability of their bureaucrats to implement disciplinary measures. For various complicated reasons -- some cultural, most historical -- South Korea and Taiwan's private industrial, mercantile, financial, and agricultural interests have been weak in challenging state authority. (In agriculture, the agrarian aristocracy was obliterated by a land reform sanctioned by the American occupying forces.) South Korea's and Taiwan's bureaucracies are modeled on that of Japan, which was expanded by the Meiji to manage technology transfer and industrial growth. The high-caliber people attracted to the bureaucracy and its competence are also partly a reflection of East Asia's general appreciation of education.

Are the "Wrong if Prices Right Everywhere?
The East Asian model is far from ideal. Labor is repressed, women are particularly exploited, business and government are in cahoots, and pollution is extreme. Nevertheless, popular movements for democracy are emerging, in part stimulated by economic growth. More to the point, this model of development is the only one that has achieved industrialization even in a handful of countries.

East Asian capitalism raises three intriguing questions:

How transferrable is it?

What does its recent success say about the standard neoclassical- economic model?

And can East Asian capitalism coexist in a trading system with other models?

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As I have suggested, the relative success of East Asian capitalism reflects private enterprise substantially disciplined by a powerful state. A strategy of "violating" market prices for capital, protecting home markets, promoting exports, and driving labor seems to work when it is rooted in institutions that offset price distortions with strict performance standards. Elsewhere, in the absence of a disciplined business-government relationship, subsidies have proven disastrous for economic development.

Though East Asian institutions may not be readily transferable to other late-industrializing countries, elements of the model may be. Most successful late industrializers have emphasized production engineering in some form of tightly-managed big business group, under a managerial sate. Invariably, countries that lack pioneering technology, whether in Asia or Europe, cannot count on the free market to industrialize and must cultivate institutions, such as planning boards or banks, if they wish to grow.

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To be sure, this paradigm does not work everywhere. Before it can he transferred, other underdeveloped nations would have to build comparable institutions consistent with their own histories. Some may simply not be able to do that. But the fad that "getting prices wrong" has worked well in several developing nations is sufficient to call into grave question the universal application claimed for the neoclassical economic model, with its deference to market-pricing. Standard economics, of course, is splendidly indifferent to the influence of history and institutions. The supreme lesson of Asian capitalism is that a highly visible hand in one form or another is necessary to provide an exit from pre-industrial poverty.

The United States does not rank high among the nations that seem promising for the East Asian model. In the past -- in the early nineteenth-century era of canals and railroads and during the New Deal and World War II -- the United States had a more activist, developmental state, but deep ideological and institutional obstacles have blocked a full-scale state-led approach. The antitrust tradition, federal system of government, investor-driven capital markets, and global sponsorship of laissez faire all militate against a state-led or corporatist approach to development in the United States.

Yet the prospects of the United States for successfully competing against the Asian model also look bleak, as the trade deficit indicates. Japan continues to demonstrate that the paradigm of late industrialization is capable of propelling borrowers of technology ever closer to the world technological frontier. They can mature into innovators without losing their original identity as learners, combining new product engineering with efficient manufacturing. The East Asian paradigm is proving hard to beat because it is rooted in the disciplined cooperation of a mixed economy, not just the free competition of a completely private one.

Challenged by new rivals, the United States is reformulating its international policies, and a debate has emerged between advocates of free trade and managed trade. Either approach, carried to an extreme, would harm the East Asian model. Developmental states are today under relentless pressure from the United States as well as the International Monetary Fund and World Bank to open their capital and product markets, abolish their subsidies, and "get their prices right" -- often to their detriment. If the United States and the Bretton Woods institutions succeed in enshrining free trade as the only permissible paradigm, the East Asian model is an outlaw. If, on the other hand, other advanced nations defensively adopt managed trade, access to their markets will depend on political bargaining power. In general, the poorer any country, the less its power to bargain for a share of managed markets.

To reduce its trade deficit, the United States is aggressively pushing for freer markets overseas while fortifying its domestic industry against foreign competition. A barometer of the America's new toughness can be seen in South Korea and Taiwan, countries that are no longer impoverished but are hardly advanced. They have had large trade deficits with Japan and large trade surpluses with the United States. America has responded by coercing South Korea and Taiwan to appreciate their currencies and to liberalize, privatize, and deregulate. Consequently, domestic investment in Taiwan is at a standstill. South Korea has begun to import more, although its growth rate has been halved. Nevertheless, despite a 65 percent depreciation of the dollar relative to the yen in 1985-87, subsidies to South Korean importers from Seoul to "buy American," and liberalization of 100 products specifically requested by the United States, the increased imports in South Korea have been Japanese, not American! American trade policy has hurt South Korea but has not benefited the United States, because American products have been unable to compete in South Korea against Japanese goods.

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Nor has Japan been particularly helpful to other late-industrializers, although Japan is now the largest foreign aid donor and investor in developing regions. The paradigm of late industrialization has enabled Japan to remain competitive in a wide range of mid-tech industries -- the big middle -- even as Japanese wages have risen and investments have been directed to high-tech sectors. According to the United Nations' 1987 Trade and Development Report, Japan's trade surplus in industries with high levels of research and development was $28 billion, compared with $5.7 billion for the United States. Its trade surplus in medium R&D intensity was much greater, at $81.5 billion, compared with a trade deficit of $59.7 billion for the United States.

Like the United States, South Korea and Taiwan have found it hard to penetrate Japanese markets. The main difference is that if Japanese mid-tech industries were more open to foreign competition, South Korea and Taiwan undoubtedly would increase their exports. The ability of the United States to compete in that market, however, is questionable.

The Challenge to Liberalism
A liberal trade policy for the United States needs to recognize that the East Asian paradigm has a significant contribution to make to the economic development of poor countries. The aim should be to co-exist with it, not put it out of business. The trading system should accept differential policies for poor countries -- including those that violate conventional ideas about pricing. Poor countries should continue to have GATT privileges, including free access to the markets of advanced countries, without having to give up their own distinct developmental strategies that incubate their fledgling industries.

In addition, late-industrializing nations should not be singled out for punishment if they run a bilateral trade surplus with the United States. The test of fair play should be rough overall trade balance. After developing states have become industrialized, they have an obligation to open their markets to import competition. But their markets should not be pried open wider than those of advanced countries, most of which are not and never have been true free traders. The IMF for example, estimates that the tariff-equivalent of West Germany's industrial incentives is 30 percent.

The model of the developmental state, if carefully applied, is too useful to banish from the permissible approaches to economic growth. Without question the East Asian development model should have begun with a more human face, but Korea and Taiwan are now democratizing and the East Asian approach is the only one proven capable of generating fast growth in the Third World. The East Asian paradigm could also prove an inspiration to the United States to rethink its laissez-faire premises and its quixotic crusade to "get prices right."